Should we fear the Brexit uncertainty?
IMF versus Krugman

IMF cuts global growth forecasts following Brexit vote. Paul Krugman has taken a different point of view by arguing there is no reason to worry in the immediate future. This opposition reflects clearly two different opinions on the short-term consequences of uncertainty.

On July 19, IMF declined its 2016 – 2017 global growth forecasts by 0.1 percentage point, compared to those published in April. These revised forecasts are mainly due to Brexit and correspond to the most optimistic scenario used by IMF. One of the most severe would conduct to a reduction by 0.3 percentage points in 2016 and 0.6 percentage points in 2017. In response to the negative outlook, IMF calls the government authorities to take all necessary steps in order to clarify what would happen after Brexit referendum.

The IMF’s point of view corresponds to a consensus widely expressed by economists and policymakers: Brexit is first and foremost a source of uncertainty that holds the economy back. However, the 2008 Nobel Laureate Paul Krugman, and a New York Times Op-Ed columnist, takes the opposite stance. He claims that Brexit will have negative consequences on aggregate activity, but only in the long run, i.e. when it will be put in place and it will modify the organization of trade agreement between the United Kingdom and the European Union. Paul Krugman is, however, skeptical about the short-term effects of Brexit uncertainty by presenting two arguments.[1]

First, and according to economic theory, a rise in uncertainty can lead a decline in investment (firms prefer to wait for a better economic environment before investing) as well as an increase (firms increase their production capacity to face different potential developments in the economic environment).

This ambiguity has been addressed by numerous empirical studies, even though macroeconomic effects turn out to be complex. Recent work has shown that these effects do exist but vary over time, depending on the state of economic and financial markets. In a tranquil state, a rise in uncertainty would have little or no effect on macroeconomic variables. According to our recent CEPII working paper[2], this situation prevailed from the 2000s until the onset of the Great Recession. However, in periods of financial distress and deep recession, a rise in uncertainty would have dramatic effects. The state of the European economy on the eve of the referendum in the United Kingdom was sufficiently worrying to think, contrary to Paul Krugman, that Brexit uncertainty would have recessive effects.

Second, Paul Krugman makes a semantic argument. Uncertainty has been improperly invoked in discussions to express the growing risk of taking a bad and extreme decision (in the Brexit case, barriers to trade in goods) while uncertainty simply means a higher probability of taking an extreme decision, good as well as bad. Paul Krugman is undoubtedly right about the terminology.

Nevertheless, at the short-term macroeconomic level, a rise in the probability of a deterioration of the economic environment in the future modifies the current state of the economy, even though the deterioration is not yet present. This is what we show, in our CEPII Working Paper, by considering the risk of deterioration in financial conditions. Even though financial conditions are good (i.e., borrowers go bankrupt without leading to big losses for lenders), the economy will be all the more sensitive to a rise in uncertainty since the risk of a deterioration of financial conditions is high. Under this circumstance, the current risk of the deterioration of economic conditions in Europe increases the European economy’s exposure to Brexit uncertainty and thus could amplify the recessive effects in the short run.
Our recent work reinforces IMF predictions. Let’s now see whether they will be right, for once.